ICI Criticizes New Decimalization System

The Investment Company Institute of Washington D.C. earlier this month asked the New York Stock Exchange to make changes to Institutional XPress, the trading system for large orders by mutual funds and other institutional investors that the exchange began using last June.

Institutional XPress has been installed as part of the NYSE's movement towards decimalization. Last June, the Securities and Exchange Commission issued an order directing the exchanges to begin devising a plan to replace fractional pricing with decimal pricing. Instead of using sixteenths or eighths of dollars, securities will move in increments of pennies or nickels, which narrows bid-ask spreads and provides simpler numbers to deal with. On Jan. 29, the NYSE completed the conversion and all of the listed securities began trading in decimals. In principle, the ICI supports that transition.

"Decimalization, by itself, is not the problem," according to Craig Tyle, general counsel to the ICI, in his March 1 letter to the NYSE. "Rather, it has simply made more apparent the difficulties that mutual funds and other institutions commonly face when trading on the Exchange."

The real problem for mutual funds is the design of Institutional XPress, which was designed specifically for large orders, according to the ICI. The system was put in place to provide increased efficiency of larger orders allowing member firms to "offer their institutional clients direct order-execution options and customized market data in formats previously unavailable," according to an NYSE statement.

"In approving the rules implementing Institutional XPress, the [SEC] stated that The XPress system should encourage market participants, particularly institutional investors, to display orders of at least 25,000 shares, which may attract more order flow and increase the depth and liquidity of the Exchange's market to the benefit of investors and the public interest,'" according to Tyle in his letter. "The Institute strongly supports this objective. Unfortunately, Institutional XPress, as currently structured, will do nothing to achieve it and instead represents a classic missed opportunity."

In its letter, the ICI recommends eliminating the time a quote is required to be displayed in order to qualify as an XPress quote, and to reduce the number of shares required for an order to qualify as an XPress order. Currently, a 30-second display time is required to make an order XPress eligible to provide brokers the opportunity to respond to a quote, according to an NYSE statement. But, that gives a free look to brokers who could then front-run, and it therefore reduces the incentive for institutions to place large limit orders since the order is not properly protected, according to the ICI.

The number of required shares, 25,000, is too high because many orders placed by mutual funds are less than that amount, especially with small-cap investments, according to the ICI.

The ICI also recommended that the price improvement mechanism be removed for XPress orders, again to protect them from early display. As it stands now, a market specialist represents an XPress order to the crowd' before it is executed so that potential sellers could improve the price of the order.

"...those institutions, including mutual funds, that would receive the benefit' of this price improvement would gladly forego it," according to Tyle. "Our members report that it is far more important for them to receive protection for their displayed orders."

The ICI further urged that XPress orders that do not necessarily represent the best bid be allowed to be executed. For example, currently, if an individual wants to buy 100 shares of a stock at $20 and a mutual fund wants to buy 25,000 shares at $19.99, the large order would not be executed. With decimalization, there is an increase in the number of price

levels at which orders are placed. As a result, fund orders are more frequently being priced below other orders and therefore are not being placed, according to the ICI. Both the larger and smaller orders should be executed and the price on the smaller order should

be improved, according to the ICI letter. Otherwise, other institutions might out

bid the initial large order, which, again,

reduces the incentive for the initial limit order, according to Tyle.

"Nobody's doing it for that very reason," said Tyle. "Price improving is fine, but not when it changes behavior."

"With [these] changes... Institutional XPress could achieve its objectives and, in turn, allow all investors in NYSE-listed securities to reap the benefits of decimalization," according to Tyle in his letter.

"We welcome input from the ICI as an organization representing major customers of the Exchange," according to an NYSE statement. "Their suggestions will be incorporated in a review of decimalization and product enhancements underway by various customer advisory committees." The Exchange declined to comment further on the recommendations.

"It's a little premature to say what's going to happen with it," said John Collins, a spokesperson for the ICI. "I've heard they're looking at the recommendations and we're certainly hopeful."

The ICI's recommendations stemmed from meetings of the equity markets advisory committee of the ICI, which considers issues that involve equity market structure, according to Tyle. The Institute has been following the issue for several months, he said.